Inflation Fears Unwarranted

Steve Rick, CUNA’s senior economist
August 6, 2009 | COMMENTS

The big question on the minds of many credit union CFOs is whether the excess liquidity pumped into the banking system by the Federal Reserve eventually will lead to increasing inflation.

If inflation increases, credit markets will respond with higher interest rates. This could present a significant risk for credit unions with large holdings in long-term, fixed-rate mortgages. This scenario could lead to falling credit union earnings as increasing funding costs outpace sluggish asset yield increases. This happened a generation ago, and contributed to the demise of hundreds of savings and loan institutions.

During the past year, the U.S. money supply--as measured by the monetary aggregate M1 (coins, currency, and demand deposits)--increased 16.2%, compared with a 20-year average of 3.2%. Could this lead to inflation resurgence?

Nobel Prize-winning economist Milton Friedman warned “inflation is always and everywhere a monetary phenomenon.” Translation: If you rapidly increase the money supply today, the consequence will be rapid inflation tomorrow. Economic research shows annual price inflation significantly correlates (with a 3.5-year lag) with annual changes in money supply.

What happens if depository institutions lend out to the private sector the $838 billion they now hold in excess reserves (up from $2 billion just over a year ago)? And then the private sector spends the funds on goods and services? Could this lead to an inflationary spike? The answer is yes, but not likely. Several factors will preclude any above-target inflation rates for the foreseeable future, including:

• The Federal Reserve's No. 1 mandate is to maintain a low and stable inflation rate. The Fed thinks this will ensure maximum sustainable economic growth in the long run. So it will counteract inflationary pressures caused by rising private sector demand by withdrawing bank liquidity and raising short-term interest rates. The Fed already has begun to withdraw some liquidity facilities as credit markets have improved.
• The economic recovery will be weaker than normal. This will limit any inflationary pressure for the next five to six years. The Congressional Budget Office estimates the current output gap--the difference between actual and potential gross domestic product--at 6.3%, near the record peak of 7.7% set in 1982. This excess capacity implies core inflation rates should trend lower even as the pace of economic growth accelerates.
• A wage-price spiral must be instituted for inflation (sustained price level increases) to really take hold. But it's unlikely with the unemployment rate headed for double-digit territory. A slack labor market forces workers to underbid each other for jobs. This will stymie wage inflation, if not create outright wage deflation.
• Excess production capacity also will contain inflation. The U.S. capacity utilization rate (present production rates as a percentage of potential production rates) was 68.3% in May--the lowest since the 1970s. Manufacturing capacity is even lower at 65%.

When utilization rates approach 82% to 84%, production bottlenecks and inflationary pressures begin to appear. Historically, it takes many years after an economic slowdown for capacity utilization rates to reach this level again.

• Market-based inflation expectations remain well-anchored. No one cares more about inflation than bond traders. Inflation erodes the purchasing power of a fixed dollar amount of bonds.

Economists measure bond traders' inflation expectations by the spread between Treasury bond interest rates and interest rates on inflation-protected bonds. Currently the interest-rate spread between the 10-year Treasury bond and the 10-year Treasury inflation-protected security is 1.57%--down from an average of 2.34% over the last seven years.

So for the next 10 years, bond market participants expect the annual inflation rate to stay below 2%.

Reprinted with permission from the August 2009 issue of Credit Union Magazine.